CHAPTER 10



CHAPTER 10

DEDUCTIONS AND LOSSES:

CERTAIN ITEMIZED DEDUCTIONS

SOLUTIONS TO PROBLEM MATERIALS

| | | | |Status: | | Q/P |

|Question/ | | | |Present | | in Prior |

|Problem | |Topic | |Edition | |Edition |

| | | | | | |

|1 | |Effect of changes in AGI on medical expense deduction | |Unchanged |1 |

|2 | |Definition of a medical expense | |Unchanged |2 |

|3 | |Cosmetic surgery as a medical expense | |Unchanged |3 |

|4 | |Nursing home expenses | |New | |

|5 | |Capital expenditure as a medical expense | |New | |

|6 | |Medical expenses of noncustodial parent | |Unchanged |6 |

|7 | |Self-employed versus employee medical insurance | |Unchanged |7 |

|8 | |Medical and casualty loss reimbursement | |Unchanged |8 |

|9 | |Health savings account (HSA) | |New | |

|10 | |Issue ID | |Unchanged |10 |

|11 | |Apportionment of real estate tax | |New | |

|12 | |Mortgage interest expense | |Unchanged |12 |

|13 | |Home equity loan | |Unchanged |13 |

|14 | |When “points” are deductible | |Unchanged |14 |

|15 | |Deduction of interest on debt between related parties |Unchanged |15 |

|16 | |Contribution to an individual | |Unchanged |16 |

|17 | |Value received for contribution | |New | |

|18 | |Issue ID | |Unchanged |18 |

|19 | |Timing of contribution | |New | |

|20 | |Issue ID | |Unchanged |20 |

|21 | |Issue ID | |Unchanged |21 |

|22 | |Issue ID | |Unchanged |22 |

|23 | |Charitable contribution: reduced deduction election |New | |

|* 24 | |Medical expense deduction and reimbursement | |Unchanged |24 |

|25 | |Medical expenses: nursing home | |New | |

|26 | |Capital expenditures as medical expense deduction | |Unchanged |26 |

|27 | |Self-employed health insurance | |Unchanged |27 |

|* 28 | |Medical expense deduction: taxpayer and dependents | |Unchanged |28 |

|29 | |Issue ID | |Unchanged |29 |

|* 30 | |Health savings accounts | |Modified |30 |

|* 31 | |Apportionment of real estate taxes: effect on basis |New | |

|32 | |State income tax deduction and refund | |New | |

|33 | |Investment interest expense: net investment income |Modified |33 |

|* 34 | |Investment interest expense | |New | |

|35 | |Home equity loan: calculation of interest expense deduction | |Unchanged |35 |

|36 | |Related party loans | |Unchanged |36 |

|37 | |Charitable contribution deduction: exception to | |Unchanged |37 |

| | |tangible-benefit-received rule | | | |

|38 | |Stock donation | |Unchanged |38 |

|39 | |Charitable contribution: reduced deduction election |Unchanged |39 |

|40 | |Application of percentage limitations to contribution of long-term capital | |Unchanged |40 |

| | |gain property | | | |

|41 | |Charitable contribution: reduced deduction election |Modified |41 |

|42 | |Tangible benefit derived, year of charitable contribution deduction | |Unchanged |42 |

|43 | |Choice of property for contribution | |Unchanged |43 |

|* 44 | |Itemized deductions: joint vs. separate returns and overall limit on | |Unchanged |44 |

| | |itemized deductions | | | |

|45 | |Overall limitation on certain itemized deductions | |Unchanged |45 |

|* 46 | |Overall limitation on certain itemized deductions | |Modified |46 |

|* 47 | |Itemized deduction limitation and exemption phase-out | |New | |

|* 48 | |Itemized deduction limitation | |Unchanged |48 |

|* 49 | |Cumulative | |Modified |49 |

|* 50 | |Cumulative | |Modified |50 |

| | | | | | | |

|Research | | | | | | |

|Problem | | | | | | |

| | | | | | |

|1 | |Interest deduction | |New | |

|2 | |Medical expenses and damage award | |Unchanged | |

|3 | |Internet activity | |New | |

*The solution to this problem is available on a transparency master.

CHECK FIGURES

24. $8,950.

25.a. $16,000.

25.b. $3,400 for Peter.

26. $14,250.

27. $7,000 for AGI; $0 from AGI.

28. $39,370.

30. $6,000 for AGI ($2,400 + $3,600); $0 from AGI.

31.a. $2,175.

31.b. $2,775.

31.c. $332,715.

32. $6,500.

34.a. Current deduction $13,100.

34.b. Carryover $6,900.

35. $100,000.

36.a. $6,000 in 2005.

36.b. $6,000 in 2006.

37.a. $3,200.

37.b. $2,880.

38.a. $15,000.

38.b. $27,000.

38.c. $10,500.

39. No.

40.a. $210,000.

40.b. Carryover for 5 years as 30% property.

41.a. $59,000.

41.b. $44,000.

42.a. $660.

42.b. No.

44. Tax savings filing separately $353.

45. $58,981.

46. $44,600 before; $36,881 after.

47. $27,465.

48. $18,481.

49. Refund due for 2003, $2,009.

50. Refund due for 2004, $5,912.

DISCUSSION QUESTIONS

1. a. Yes. Fifty percent of the business entertainment expenses, in this situation, are deductible for AGI, which is the base for determining the nondeductible portion of the medical expenses (i.e., 7.5% X AGI). A lower AGI may result in a larger medical expense deduction. p. 10-3

b. Yes. Any unreimbursed entertainment expenses incurred by an employee would have no effect on the determination of adjusted gross income because the amounts are deductible from AGI. Therefore, the expenses would not change the base (AGI) for determining the allowable medical expenses. See Chapter 9 for a discussion of entertainment expenses.

2. Tanesha may not include as medical expenses the following items that were incurred for the general improvement of her health:

• $840 dues at a health club incurred for the purpose of improving her general physical condition.

• $240 for multiple vitamins and antioxidant vitamins.

She may include as medical expenses the $500 cost of the smoking cessation program, but may not include the $240 cost of the nonprescription nicotine gum. While the cost of nonprescription drugs is generally not deductible, the $600 spent on insulin is deductible. Funeral expenses of $7,200 do not qualify as medical expenses.

pp. 10-3 and 10-4

3. Cosmetic surgery is necessary (and therefore deductible) when it ameliorates (1) a deformity arising from a congenital abnormality, (2) a personal injury, or (3) a disfiguring disease. Expenses incurred in connection with the restorative surgery (required as a result of the accident) are deductible because the surgery was necessary. Amounts paid for the unnecessary cosmetic surgery (reshaping the chin) are not deductible as a medical expense. Examples 2 and 3

4. Helen may include the entire amount paid to the nursing home ($3,000 per month) if the primary reason for being in the nursing home is to get medical care. If the primary reason for being in the nursing home is personal, Helen may include only the $1,400 cost of medical care in calculating her medical expense deduction. p. 10-5

5. The full cost of certain home-related capital expenditures incurred to enable a physically handicapped individual to live independently and productively qualifies as a medical expense. Qualifying costs include expenditures for constructing entrance and exit ramps to the residence, widening hallways and doorways to accommodate wheelchairs, installing support bars and railings in bathrooms and other rooms, and adjusting electrical outlets and fixtures. These expenditures are subject to the 7.5% floor only, and the increase in the home’s value is deemed to be zero. pp. 10-6 and 10-7

6. Bob may be able to include the payments related to Harriett’s injury with his own medical expenses. For divorced parents with children, the noncustodial parent may claim any medical expenses he or she pays even though the custodial parent claims the children as dependents. This rule applies if the dependency exemption could have been shifted to the noncustodial parent by the custodial parent’s waiver (see Chapter 3). pp. 10-6 and 10-7

7. David, who is self-employed, may deduct 100% of the premium of $7,500 as a deduction for AGI. Joan, who is an employee, may include the premiums of $8,000 she paid in computing her itemized deduction for medical expenses (subject to the 7.5% floor). Example 10

8. Arturo, a calendar year taxpayer, paid $16,000 in medical expenses in 2004. Even if he expects $12,000 of these expenses to be reimbursed by an insurance company in 2005, he can include all $16,000 of the expenses in determining his medical expense deduction for 2004. He is not required to consider the potential reimbursement in computing his medical expense deduction for 2004.

Casualty losses must be reduced if there is an expectation of reimbursement. Therefore, Arturo’s starting point in computing the casualty loss deduction is $6,000 ($20,000 loss – $14,000 expected reimbursement). Further reductions are required for the $100 floor and the 10% of AGI floor.

p. 10-9

9. A Health Savings Account (HSA) plan includes two components: a high-deductible medical insurance policy and a Health Savings Account. The high-deductible policy covers medical expenses beyond the deductible amount, while expenses not covered by the high deductible policy can be paid with funds withdrawn from the HSA. Individuals who contribute to HSAs may deduct the contributions as deductions for AGI.

Earnings on HSAs are not included in gross income of the current year. HSA distributions that are used to pay for medical expenses not covered by a high-deductible policy are excluded from gross income. However, distributions used for purposes other than the payment of medical expenses are included in gross income and are subject to an additional 10% penalty if made before age 65, death, or disability.

pp. 10-9 to 10-11

10. Ahmad should be concerned with the following tax issues:

• Is the value of the certificate includible in gross income in 2003, even though it appeared at that time that Ahmad would not have any need for the operation?

• If Ahmad uses the certificate for his daughter, is the prize includible in gross income in 2004?

• If Ahmad pays for the prescription glasses for his daughter, can he take a medical expense deduction?

• If Ahmad uses the certificate for an operation for his daughter, can he take a medical expense deduction? If so, what is his basis in the certificate and what is the amount of his medical expense deduction?

Chapter 4 and pp. 10-2 to 10-7

11. Even though Antonio paid all the real property taxes for 2004, they must be prorated for deduction purposes. Antonio can deduct property taxes for the period he owned the property (January 1 through June 30). Mina can deduct property taxes related to the period she owned the property (July 1 through December 31), even though she did not actually pay the taxes. Antonio will treat the taxes he paid on Mina’s behalf as a reduction of the amount realized on the sale, and Mina must treat this amount as a reduction in her basis for the property. pp. 10-12, 10-13, and Example 19

12. Julia can deduct mortgage interest on her principal residence and one of the two other residences. She should choose the one that will result in the highest interest deduction. Her deduction is limited to interest on up to (1) $1,000,000 of acquisition indebtedness, and (2) $100,000 of home equity indebtedness. Julia should consider consolidating the three mortgages into two if possible. p. 10-16

13. Home equity loans utilize a qualified residence of the taxpayer as security. The proceeds from these loans can be used for personal purposes. By making use of home equity loans, therefore, what would have been nondeductible consumer interest becomes deductible qualified residence interest. Ed apparently obtained a home equity loan, and Jack did not. p. 10-16 and Example 24

14. Points paid by a seller are treated as an adjustment to the selling price of the residence. The buyer is treated as having used cash to pay the points that were paid by the seller. The buyer may deduct the points if several conditions are met. These conditions are specified in Rev. Proc. 94-27, which is cited in footnote 31. p. 10-17

15. Because of the irregular patterns of interest payments, it does not appear that this is a bona fide loan. Interest paid was $3,200 in 2002, $0 in 2003, and $9,000 in 2004. Additionally, the interest would not represent deductible qualified residence interest unless the loan was secured by the condominium. pp. 10-16 to 10-18

16. Contributions are deductible only if made to a qualified charitable organization. The family would not qualify as a charitable organization, so Betty’s contribution will not be deductible. The church probably would be a qualified charitable organization. If so, Jack’s contribution will be deductible. p. 10-21

17. A taxpayer cannot take a deduction to the extent he/she receives a personal benefit. Therefore, Andy is not entitled to a deduction because his contribution enabled his daughter to attend the parochial school. p. 10-20

18. Nancy should consider the following tax issues if she acquires the notebook computer under the conditions specified:

• Can she take a charitable contribution deduction for the $1,000 donation to the university? To the extent the taxpayer receives a benefit from a contribution, the charitable contribution deduction is not allowed. Nancy would be the sole user of the computer and would receive a personal benefit from the contribution.

• Will she be allowed to take a depreciation deduction for the business use of the computer? If Nancy contributes $1,000 to the university, the university owns the computer. Therefore, she is not entitled to a depreciation deduction.

• Is Nancy required to report income as a result of her personal use of the computer? Nancy should report income to the extent of the value of the computer usage for personal use. It does not appear that the de minimis fringe benefit rule would allow an exclusion from gross income.

• What could Nancy do to avoid the negative tax consequences discussed above? Nancy could purchase a computer for $2,500. She could take a depreciation deduction for the business use (limited by the listed property rules), and would not be required to report income from personal use of the computer.

pp. 10-19 to 10-22

19. Harry is attempting to accelerate his charitable contribution deduction into 2004. There are several potential advantages to accelerating the deduction by donating the land in 2004.

• His contribution will be deducted in a tax year when his combined Federal/state marginal tax rate is 40% (2004) rather than 30% (2005).

• He might avoid disallowance of part of the deduction due to AGI percentage limitations because his contribution base will be higher in 2004 than in 2005.

• He can deduct the fair market value of the land without recognizing the $80,000 appreciation as income.

• He can step up his basis in the land from $20,000 to $100,000 when he reacquires it in 2005.

Harry’s plan will generate many favorable outcomes if he does not run afoul of the IRS. While it does not appear that Harry has done anything that does not comply with the tax law, the IRS might collapse the transaction; that is, focus on the outcome and ignore the steps involved. The outcome is that Harry has transferred $100,000 cash to his church. The IRS might disallow the deduction for the land contribution in 2004 and treat the transaction as a cash contribution in 2005. In this case, Harry’s basis for the purchased land would be $20,000 and his deduction would be at the lower 2005 marginal tax rate. pp. 10-22 to 10-27

20. The following issues relate to the assets Zina sold:

• Should the $500 sales receipts be reported on her tax return?

• What was her basis for the assets she sold?

• Did she have a gain or loss on the sale?

• Were the assets used for personal use, trade or business, or production of income?

• Were the assets capital assets or ordinary income assets?

• If she sold capital assets, were they held short-term or long-term?

The following issues relate to the assets Zina donated:

• Does she plan to itemize deductions?

• Which organizations were recipients of the donated items?

• Were the organizations qualified charitable organizations?

• What types of assets did she donate, ordinary income assets or capital gain assets?

• What was her basis for the assets she donated?

• What was the fair market value of the assets she donated?

• How did she determine the fair market value of the items?

pp. 10-19 to 10-27

21. Edward has created a rather complex set of tax questions with his decision to return the check to the governor. The primary issues are listed below:

• Is Edward required to treat the $290 as if he constructively received it, or may he ignore having received the check?

• If the constructive receipt rule applies, is Edward required to report the rebate as income in 2003?

• The answer would depend on whether Edward had itemized deductions in 2002. If so, he would be required to report income in 2003 under the tax benefit rule. If not, he would not be required to report income.

• Is Edward entitled to a charitable contribution deduction of $290?

• If the constructive receipt rule applies, and if Edward were required to report income in 2003 under the tax benefit rule, he would be entitled to a charitable contribution deduction in 2004, the year he returned the check.

• If the constructive receipt rule does not apply, Edward would not be required to report income in 2003, and would not be entitled to a charitable contribution deduction in 2004.

p. 10-22

22. The following tax issues relate to prizes won in the Skins Game:

• Are the prizes won (monetary and nonmonetary) included in gross income?

• Should the players report only 80% of the total amount of money winnings as income and claim no deduction for the amount that goes to charity?

• Should the players report the total amount of money winnings as income and deduct the 20% that goes to charity as a charitable contribution? If so, is the deduction a business expense or an itemized deduction?

• What amount should be reported as income for the automobile won by the leading money winner—the sticker price, the average selling price, or some other amount?

• If the average selling price is the appropriate amount to report as income, how should it be determined?

Chapter 4 and pp. 10-19 to 10-23

The following questions relate to material covered in later chapters:

• If the leading money winner already has an automobile and doesn’t need the new one, what will be the tax result when he sells the automobile he won as a prize? What is his basis in the automobile won as a prize? What kind of gain (loss) would result? If a loss results, is it deductible? Chapters 13 and 14

• If the leading money winner keeps the automobile he won as a prize and sells the automobile he had been using previously, what will be the tax result when he sells his old automobile? What kind of gain (loss) would result? If a loss results, is it deductible? Chapters 13 and 14

• What will be the tax result if the leading money winner gives the new automobile to a friend or relative? Chapter 13

• What will be the tax result if the leading money winner gives the new automobile to a charity? Chapter 13

• What will be the tax result if the leading money winner gives the new automobile to his caddy, who is an employee? Chapter 13

23. General discussion. The stock is appreciated long-term capital gain property. The general rule limits the deduction for the contribution of such property to 30% of AGI. However, under the reduced deduction election, a taxpayer may choose to forgo a deduction of the appreciation on capital gain property. This enables the taxpayer to move from the 30% limitation to a 50% limitation.

a. Colin can deduct a total of $105,000, the fair market value of the stock. The deduction for 2004 is limited to $54,000 (30% of $180,000 AGI). The remaining $51,000 ($105,000 – $54,000) can be carried forward and deducted in the future, subject to the same percentage limitations.

b. If Colin makes the reduced deduction election, he can deduct $84,000 (adjusted basis) in 2004, but he will forgo a deduction for the $21,000 appreciation ($105,000 FMV – $84,000 adjusted basis).

c. Although the reduced deduction election appears attractive, it should be considered carefully. The election sacrifices a deduction for the appreciation on long-term capital gain property that might eventually be allowed. Colin should do a time value analysis to compare the value of a deduction of $84,000 in 2004 versus the value of a $54,000 deduction in 2004 plus $51,000 of deductions to be carried over to future years.

d. If Colin dies in December 2004, his executor should make the reduced deduction election, which would yield a charitable contribution deduction of $84,000. If the election is not made, the deduction will be $54,000 (30% of $180,000) and the $51,000 carryover will be lost because the 2004 return will be the final return for Colin.

pp. 10-23 to 10-27 and Example 36

PROBLEMS

24. Emma’s medical expense deduction is $8,950, determined as follows:

Medical insurance premiums $ 3,700

Doctor and dentist bills for Bob and April 6,800

Doctor and dentist bills for Emma 5,200

Prescribed medicines for Emma 400

Nonprescribed insulin for Emma 350

Total medical expenses $16,450

Less: 7.5% of $100,000 (AGI) (7,500)

Deductible portion of medial expenses $ 8,950

Although Bob and April cannot be claimed as Emma’s dependents, they could have been had they not filed a joint return. Therefore, they qualify for the medical expense deduction. Insulin is an exception to the rule that nonprescribed drugs do not qualify as medical expenses. The insurance recovery was not received until 2005. Therefore, it has no effect on the medical expense deduction for 2004.

pp. 10-2 to 10-9 and Exhibit 10-1

25. a. $16,000 ($12,000 + $4,000) for Jonathan. p. 10-5

b. $3,400 for Peter. Going to Riverview Manor appears to be a matter of personal choice and not necessitated by medical reasons. p. 10-5 and Example 4

26. Only $13,500 qualifies since $2,000 of the $15,500 cost of the elevator increased the value of Jung’s residence. The total medical expense is $14,250 ($13,500 + $750 additional operating costs). The $500 appraisal fee is deductible as a miscellaneous itemized deduction, but not as a medical expense. Example 6

27. Self-employed persons can deduct 100% of their medical insurance premiums as a deduction for AGI in 2004. Thus, Jean may deduct $7,000 as a deduction for AGI. p. 10-8

28. The charges for tuition, room, and board paid to Red River Academy qualify because Beth receives specialized psychiatric treatment. Example 5

Although Ed does not qualify as Susan’s dependent, he qualifies as a dependent for medical expense purposes. All of the costs paid for Ed at Heartland Nursing Home are deductible because the primary reason he is there is to receive medical care. p. 10-4 and Exhibit 10-1

Prescription drugs and insulin are deductible, but nonprescription drugs are not.

Only $4,300 of the filtration system qualifies since $2,200 of the $6,500 cost increased the value of Susan’s residence. The $700 increase in utility bills also is a medical expense. The appraisal fee of $360 is an itemized deduction, but is not deductible as a medical expense. Example 6

Deductible medical expenses are summarized below:

Surgery for Beth $ 4,200

Red River Academy charges for Beth:

Tuition 5,600

Room, board, and other expenses 4,800

Psychiatric treatment 5,100

Doctor bills for Ed 2,200

Prescription drugs for Susan, Beth, and Ed 780

Insulin for Ed 540

Charges at Heartland Nursing Home for Ed:

Medical care 4,800

Lodging 3,700

Meals 2,650

Deductible cost for filtration system ($6,500 – $2,200) 4,300

Increase in utility bills due to the system 700

Total medical expenses (prior to the 7.5% floor) $39,370

29. The following tax issues are suggested by the facts presented:

• Can Rebecca claim Susan as a dependent?

• Can Rebecca take a medical expense deduction for the remodeling expenditures?

• Can Rebecca take a medical expense deduction for the swimming pool expenditures?

• Can Rebecca take a medical expense deduction for the cost of Susan’s operation?

• Can Susan take a medical expense deduction for the specially equipped van and the costs of operating it?

• Can Rebecca take a medical expense deduction for the traveling expenses (transportation, highway tolls, meals, and lodging)?

• Can Rebecca deduct the medical expenses incurred for Susan if Susan does not qualify as her dependent?

The following questions should be asked to resolve some of the issues listed above:

• Did Rebecca provide more than half of Susan’s support? This will determine whether Rebecca can deduct Susan’s medical expenses. In addition, Rebecca may be able to claim head of household filing status if Susan lived with her for more than half the year.

• Are the remodeling expenses necessary in order to enable Susan to live independently? If so, the expenses are included in medical expenses subject to the 7.5% floor.

• Is the travel to Denver necessary in order for Susan to receive proper medical treatment? If it is, the travel expenses are included in medical expenses subject to the 7.5% floor.

• How much expense did Rebecca incur for lodging? The deduction is limited to $50 per night per person.

pp. 10-4 to 10-8 and Chapter 3

30. Because Felicia is self-employed, she can deduct $2,400 ($200 per month X 12 months) of the amount paid for the high-deductible policy as a deduction for AGI (refer to Example 10). In addition, she may deduct the $3,600 paid to the HSA as a deduction for AGI. Thus, Felicia may deduct $6,000 ($2,400 + $3,600) for AGI.

pp. 10-9 to 10-11

31. General discussion. Real property taxes must be apportioned between the buyer and the seller, regardless of whether the buyer or seller pays the taxes. In making the apportionment, the date of sale counts as a day the property is owned by the buyer. Because 2004 is a leap year, the tax is apportioned over 366 days.

a. Rate of tax per day ($5,490/366) $ 15

Days Phil owned property (January 1 - June 29) X 181

Taxes apportioned to Phil ($15 X 181) $2,715

b. Rate of tax per day ($5,490/366) $ 15

Days Cheryl owned property (June 30 - December 31) X 185

Taxes apportioned to Cheryl ($15 X 185) $2,775

c. Purchase price of house $330,000

Taxes paid by Cheryl, apportioned to Phil 2,715

Cheryl’s basis $332,715

pp. 10-12 and 10-13

32. The itemized deduction is $6,500 ($1,200 + $1,500 + $1,500 + $1,500 + $800). The deduction includes the four payments made in 2004 and the $800 overpayment credited to 2004’s tax. p. 10-14

33. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH  45040

February 20, 2005

Ms. Carol Sharp

208 Lone Tree Circle

Napa, CA 94558

Dear Ms. Sharp:

In our recent meeting, you asked me to determine the amount of your investment interest deduction for 2004. The amount of your deduction will depend on choices that you make with regard to the treatment of the $12,750 net capital gain on the sale of securities.

The deduction for investment interest is limited to the amount of investment income that you report. If you choose not to treat the net capital gain as investment income for purposes of computing the investment interest expense limitation, your deduction will be $12,500 ($7,000 interest + $5,500 dividends).

However, if you elect to treat the net capital gain as investment income for purposes of computing the investment interest expense limitation, your deduction will be $25,250 ($7,000 interest + $5,500 dividends + $12,750 net capital gain).

If you elect to include the capital gains as investment income, your $12,750 net capital gain will not qualify for beneficial tax rate treatment. Therefore, you must decide between the tax benefit of an additional deduction of $12,750 versus the benefit of the reduced rates applicable to net capital gain.

Due to the complexities of the capital gain provisions, I will need to meet with you again to obtain additional information in order to advise you about the election that is available. Please call me at (510) 555-1234 to schedule an appointment. Thank you for consulting my firm on this matter. We look forward to serving you in the future.

Sincerely,

Julie Morgan, CPA

Partner

pp. 10-14 and 10-15

34. a. Angela’s investment interest deduction is limited to net investment income, which is computed as follows:

Income from investments $14,100

Less: Investment expenses* (1,000)

Net investment income $13,100

*Because Angela has no other miscellaneous itemized deductions, the deductible investment expenses are the smaller of (1) $3,000, the amount of investment expenses included in the total of miscellaneous itemized deductions subject to the 2% of AGI floor, or (2) $1,000, the amount of miscellaneous expenses deductible after the 2% of AGI floor is applied [$3,000 – $2,000 (2% of $100,000 AGI)].

Angela’s investment interest expense deduction in 2004 would be limited to $13,100, the amount of net investment income. The balance of $6,900 would be disallowed in 2004.

Total investment interest expense $20,000

Less: Net investment income (13,100)

Investment interest disallowed in 2004 $ 6,900

b. The $6,900 of investment interest disallowed may be carried over and becomes investment interest expense in the subsequent year subject to the net investment income limitation in 2005. Angela could increase her investment interest deduction by electing to treat the LTCG as investment income. If she makes the election, the amount so elected would not be available for beneficial alternative tax rate treatment for net capital gain.

pp. 10-15 and 10-16

35. Interest is deductible only on the portion of a home equity loan that does not exceed the lesser of:

• The fair market value of the residence, reduced by the acquisition indebtedness ($220,000 FMV – $70,000 acquisition indebtedness = $150,000).

• $100,000 ($50,000 for married persons filing separate returns).

Huseyin can deduct all of the interest on the first mortgage since it is acquisition indebtedness. Of the $110,000 home equity loan, interest on $100,000 is deductible as home equity interest. Examples 24 and 25

36. a. Robin Corporation can deduct interest expense of $6,000 in 2005. No interest deduction is permitted in 2004. Under § 267, Ron and Tom are regarded as related to the corporation. Consequently, the deductibility must await actual payment in 2005.

b. All of the interest of $6,000 is included in the gross income of Ron and Tom in 2005. Because they use the cash method of accounting, income is not taxed until received in 2005.

p. 10-18 and Chapter 6

37. Generally, when a donor derives a tangible benefit from a contribution, he or she cannot deduct the value of the benefit. An exception to this benefit rule provides for the deduction of 80% of the amount paid for the right to purchase athletic tickets from colleges and universities. Example 30

a. Under the exception to the benefit rule, Nadia is allowed a $3,200 (80% of $4,000) charitable contribution deduction for the taxable year. None of the $400 paid for game tickets can be deducted.

b. Nadia cannot deduct the $400 portion of the $4,000 that applies to the tickets ($100 X 4). She is allowed a charitable contribution deduction of $2,880, which is equal to 80% of the $3,600 remainder.

38. General discussion. The deduction for a contribution of long-term capital gain property is based on fair market value, while the deduction for a contribution of ordinary income property is equal to the lesser of the adjusted basis or fair market value.

a. Because Kristin did not hold the stock for the long-term holding period, it is short-term capital gain property that is subject to the rules for ordinary income property. Therefore, her deduction is limited to $15,000.

b. Kristin held the stock for the long-term holding period, so it is long-term capital gain property. Therefore, her deduction is equal to the fair market value of the stock of $27,000.

c. The deduction for a contribution of loss property (FMV < adjusted basis) is limited to the fair market value. Therefore, Kristin’s deduction is $10,500. Example 32 and related discussion

pp. 10-24 and 10-25

39. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH  45040

December 5, 2004

Mr. Pedro Valdez

1289 Greenway Avenue

Foster City, CA 94404

Dear Mr. Valdez:

I have evaluated the two alternatives for your charitable contribution deduction. Your potential deduction is $130,000, the fair market value of the painting. It is not reduced by the unrealized appreciation since the painting was assumed to be put to a related use by the museum and the holding period is long-term. Your 2004 charitable contribution deduction is limited to $75,000 (30% X $250,000 AGI) if you do not make the reduced deduction election. The remaining $55,000 ($130,000 FMV – $75,000 deduction) can be carried forward for five years.

If you make the reduced deduction election, you can deduct $90,000 (adjusted basis of the painting) in 2004, because the amount is less than the maximum potential deduction of $125,000 (50% X $250,000 AGI). However, if you make the election, you must forgo deducting the $40,000 appreciation on the painting ($130,000 FMV – $90,000 adjusted basis). Based on the facts presented, it does not appear that you should make the reduced deduction election. You would be forgoing an additional deduction of $40,000 in order to increase your 2004 deduction from $75,000 to $90,000. You should plan your contributions carefully over the next five years so that you do not lose any of the $55,000 carryover.

I will be pleased to discuss my recommendation in further detail if you wish. Please call me at (510) 555-1234 if you have any questions. Thank you for consulting my firm on this matter. We look forward to serving you in the future.

Sincerely,

Carol Eckert, CPA

Partner

pp. 10-23 to 10-27

40. a. No reduction for the appreciation on the Goshawk, Inc. stock is necessary because, if sold, it would yield a long-term capital gain. Thus, Alvin’s potential charitable deduction is $250,000 [$110,000 (cash) + $140,000 (fair market value of Goshawk, Inc. stock)], but his allowable contribution deduction for the year is limited to $210,000 (50% of $420,000 AGI).

Although the 30% of AGI limitation applies to long-term capital gain property, which would result in a current deduction for the Goshawk, Inc. stock of $126,000 (30% of $420,000 AGI), the overall 50% of AGI limitation applies to limit the deduction to $100,000. When the contributions for the tax year involve both 50% property (the cash of $110,000 in this case) and 30% property (the Goshawk, Inc. stock), the allowable deduction comes first from the 50% property. Therefore, Alvin’s allowable deduction of $210,000 for the current year consists of:

Cash $110,000

Goshawk stock [overall limitation of $210,000 (50% of AGI)

– $110,000 (cash)] 100,000

$210,000

pp. 10-23 to 10-27 and Example 35

b. The unused portion of the Goshawk stock contribution of $40,000 [$140,000 (fair market value) – $100,000 (portion used)] may be carried over for five years. The carryover continues to be classified as 30% property in the carryover years. p. 10-26

If Alvin plans his charitable deductions wisely, sooner or later he will be able to deduct the full $140,000 fair market value of the stock.

41. General discussion. The stock is appreciated long-term capital gain property. The general rule limits the deduction for the contribution of such property to 30% of AGI. However, under the reduced deduction election, a taxpayer may choose to forgo a deduction of the appreciation on capital gain property. This enables the taxpayer to move from the 30% limitation to a 50% limitation.

a. Julian can deduct a total of $59,000, the fair market value of the stock. The deduction for 2004 is limited to $30,000 (30% of $100,000 AGI). The remaining $29,000 can be carried forward and deducted in the future, subject to the same percentage limitations.

b. If Julian makes the reduced deduction election, he can deduct $44,000 in 2004, but he will forgo a deduction for the $15,000 appreciation ($59,000 FMV – $44,000 adjusted basis).

c. Although the reduced deduction election appears attractive, it should be considered carefully. The election sacrifices a deduction for the appreciation on long-term capital gain property that might eventually be allowed. Julian should do a time value analysis to compare the value of a deduction of $44,000 in 2004 versus the value of a $30,000 deduction in 2004 plus $29,000 of deductions to be carried over to future years.

d. If Julian dies in December 2004, his executor should make the reduced deduction election, which would yield a charitable contribution deduction of $44,000. If the election is not made, the deduction will be $30,000 (30% of $100,000) and the $29,000 carryover will be lost because the 2004 return will be the final return for Julian.

pp. 10-23 to 10-27 and Example 36

42. a. Based on these facts, Roberta can deduct $660 as a charitable contribution for 2004. The deduction is based on the difference between the purchase price of the four tickets (4 X $200) and their fair market value (4 X $35). Giving the tickets to the minister is of no consequence, because the minister is not a qualified charity. pp. 10-20 to 10-22

b. The pledge to the building fund of the church yields no deduction for 2004. In this regard, it makes no difference whether Roberta uses the cash or the accrual method of accounting for tax purposes. Except for limited exceptions involving accrual basis corporations and fiduciary entities, charitable donations are deductible only in the year in which they are paid. Had the check that satisfied the pledge been mailed on December 31, 2004, Roberta could have claimed a deduction for 2004. As the situation is described, however, the $4,000 deduction relates to 2005. p. 10-22

43. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH  45040

December 5, 2004

Ms. Alice Young

2622 Bayshore Drive

Berkeley, CA 94709

Dear Ms. Young:

I have evaluated the proposed alternatives for your 2004 year-end contribution to the United Way. I recommend that you sell the Gold Corporation stock and donate the proceeds to the United Way. The four alternatives are discussed below.

Donation of cash, the unimproved land, or the Gold stock will each result in a $21,000 charitable contribution deduction. Donation of the Blue Corporation stock will result only in a $3,000 charitable contribution deduction.

A direct contribution of the Gold Corporation stock will be a bad move taxwise in that the decline in value of $5,000 ($21,000 – $26,000) is not deductible and the amount of the charitable contribution would be $21,000. However, you will benefit in two ways if you sell the Gold stock and give the $21,000 in proceeds to the United Way. Donation of the proceeds will result in a $21,000 charitable contribution deduction. In addition, sale of the stock would result in a $5,000 long-term capital loss. If you have capital gains of $2,000 or more in 2004, you could use the entire loss in computing taxable income for 2004. If you have no capital gains in 2004, you can deduct $3,000 of the capital loss in 2004 and carry the remaining $2,000 over to 2005.

You should make the donation in time for ownership to change hands before the end of the year. Therefore, I recommend that you notify your broker immediately so there will be no problem in completing the donation on a timely basis.

I will be pleased to discuss my recommendation in further detail if you wish. Please call me at (510) 555-1234 if you have questions. Thank you for consulting my firm on this matter. We look forward to serving you in the future.

Sincerely,

Nora Oldham, CPA

Partner

Example 44

44. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH  45040

January 20, 2005

Mr. and Mrs. Manuel Garcia

5904 Stevens Avenue

Durham, NC 27707

Dear Mr. and Mrs. Garcia:

I have reviewed the tax information you provided and have determined that you will save $353 in Federal income tax if you file separate returns for 2004. While it is usually advantageous to file jointly, that is not the case for you this year because of Manuel’s high medical expenses and his unreimbursed employee expenses. A detailed computation that supports my recommendation is enclosed.

I will be pleased to discuss my recommendation in further detail if you wish. Please call me at 555-9999 if you have questions. Thank you for consulting my firm on this matter. We look forward to serving you in the future.

Sincerely,

Rodney Rodriguez, CPA

Partner

Manuel and Rosa Garcia

Comparison of Joint and Separate Tax Liabilities

Tax Year 2004

Separate and joint tax liabilities for 2004 are computed as shown below. These computations are based on all information provided by Manuel and Rosa Garcia.

Manuel Rosa Joint

Salary $40,000 $ 40,000

Business net income $100,000 100,000

Interest income** 1,500 2,300 3,800

Gross income $41,500 $102,300 $143,800

Deductions for AGI (2,000) (13,000) (15,000)

AGI $39,500 $ 89,300 $128,800

Medical expenses after 7.5% floor $ 6,538 $ -0- $ 440

State income tax 800 2,000 2,800

Real estate tax 1,700 1,700 3,400

Mortgage interest 2,600 2,600 5,200

Unreimbursed employee expenses after 2% 310 -0- -0-

floor

Total itemized deductions $11,948 $ 6,300 $ 11,840

Limited to 5,761*

Exemptions 3,100 3,100 6,200

Total deductions from AGI (15,048) (8,861) (18,040)

Taxable income $24,452 $ 80,439 $110,760

Tax $ 3,310 $ 17,502 $ 21,165

Savings filing separately:

Tax filing jointly $ 21,165

Tax filing separately ($3,310 + $17,502) (20,812)

Savings $ 353

*Itemized deduction limitation:

AGI $89,300

Minus threshold (71,350)

$17,950

X .03

Reduction $ 539

Total itemized deductions $ 6,300

Reduction (539)

$ 5,761

**Interest income:

Manuel Rosa

Manuel’s interest $ 400

Rosa’s interest $1,200

Their joint interest 1,100 1,100

$1,500 $2,300

pp. 10-29 and 10-30

45. For the medical expenses, the taxpayers are allowed $5,000 [$23,000 – (7.5% X $240,000)]. The casualty loss must first be reduced by $100 and then by $24,000 (10% X $240,000). Thus, only $1,900 [$26,000 – $24,100 ($100 + $24,000)] can be deducted. Note that neither the medical expenses nor the casualty loss is subject to the overall limitation on itemized deductions.

Regarding the overall limitation, the cutback adjustment is $2,919 [3% X ($240,000 – $142,700)]. Because the covered itemized deductions total $55,000 ($10,000 + $13,000 + $17,000 + $15,000) and 80% of $55,000 is $44,000, the 80% rule does not apply (use the lesser of $2,919 or $44,000).

Consequently, the taxpayer’s allowable itemized deductions for 2004 are $5,000 (medical) + $1,900 (casualty) + $52,081 ($55,000 – $2,919), or $58,981.

Example 38

46. Charles’s itemized deductions before the overall limitations are computed below:

Medical expenses [$39,500 – (7.5% X $400,000)] $ 9,500

State and local income taxes 5,200

Real estate taxes 4,400

Home mortgage interest 5,400

Charitable contributions 4,800

Casualty loss [$47,000 – (10% X $400,000)] 7,000

Unreimbursed employee expenses [($8,900 – (2% X $400,000)] 900

Gambling losses ($9,800 loss limited to $7,400 of gambling income) 7,400

Total itemized deductions before overall limitation $44,600

Charles’s itemized deductions after application of the overall limitation are computed below:

Itemized deductions subject to overall limitation:

State and local income taxes $ 5,200

Real estate taxes 4,400

Home mortgage interest 5,400

Charitable contributions 4,800

Unreimbursed employee expenses 900

Total $20,700

Reduction equals the smaller of the following:

3% X ($400,000 AGI – $142,700) $ 7,719

80% of itemized deductions subject to limitation 16,560

($20,700 X 80%)

Amount of reduction (7,719)

Deductible itemized deductions subject to overall limitation $12,981

Itemized deductions not subject to overall limitation:

Medical expenses 9,500

Gambling losses 7,400

Casualty loss 7,000

Total itemized deductions $36,881

pp. 10-29, 10-30, and Example 38

47. For purposes of working with the 3% rule, the excess amount is $134,600 [$277,300 (AGI) – $142,700 (threshold amount)]. Thus, the 3% rule yields a potential reduction of $4,038 (3% X $134,600).

Under the 80% exception, the reduction cannot be more than 80% of the covered itemized deductions. Thus, 80% X $24,300 [$8,700 (interest on home mortgage) + $9,500 (state income tax) + $3,600 (real estate tax) + $2,500 (charitable contribution)] equals $19,440.

Consequently, Evan can claim $20,262 ($24,300 – $4,038) + $7,203 [$28,000 (medical expenses) – (7.5% X $277,300) = $7,203 rounded], or a total of $27,465 of itemized deductions.

Example 38

48. Thomas’s itemized deductions before the overall limitation are computed as follows:

Medical expenses [$20,000 – (7.5% X $240,000)] $ 2,000

State and local income taxes 3,900

Real estate taxes 2,100

Home mortgage interest 4,400

Charitable contributions 4,500

Casualty loss [$25,000 – (10% X $240,000)] 1,000

Unreimbursed employee expenses [$5,600 – (2% X $240,000)] 800

Gambling losses ($4,900 loss limited to $2,700 of gambling income) 2,700

Total itemized deductions before overall limitation $21,400

Thomas’s itemized deductions subject to the overall limitation are as follows:

Itemized deductions subject to overall limitation:

State and local income taxes $ 3,900

Real estate taxes 2,100

Home mortgage interest 4,400

Charitable contributions 4,500

Unreimbursed employee expenses 800

Total $15,700

Thomas must reduce this amount by the smaller of the following:

3%($240,000 AGI – $142,700) $ 2,919

80% of itemized deductions subject to limitation 12,560

($15,700 X 80%)

Therefore, the amount of the reduction is $2,919 and Thomas has $18,481 of deductible itemized deductions, computed as follows:

Deductible itemized deductions subject to overall limitation $12,781

($15,700 – $2,919)

Itemized deductions not subject to overall limitation:

Medical expenses 2,000

Casualty losses 1,000

Gambling losses 2,700

Deductible itemized deductions $18,481

Example 38

CUMULATIVE PROBLEMS

49. Tax Computation

Bruce’s salary $53,000

Alice’s salary 42,000

Interest income 2,450

Adjusted gross income $97,450

Less: Itemized deductions (Note 1) (29,861)

Less: Personal and dependency exemptions

(Bruce, Alice, 2 children, Alice’s mother, and Bruce’s father) (Note 2) (18,300)

Taxable income $49,289

Tax from Tax Table $ 6,691

Less: Prepayments and credits

Income tax withheld ($3,800 + $4,900) (8,700)

Net tax payable (or refund due) for 2003 ($ 2,009)

See the tax return solution beginning on p. 10-25 of the Solutions Manual.

Notes

(1) Itemized deductions are summarized below:

Medical expenses:

Medical insurance premiums $ 7,100

Doctor bill paid in 2003 for services in 2002 2,800

Operation for Bruce’s father (a dependent under a

multiple support agreement) 6,100

Total medical expenses $16,000

Less: 7.5% of $97,450 AGI (7,309)

Medical expenses deductible in 2003 $ 8,691

Taxes:

State income taxes ($3,700 + $800) $ 4,500

Property taxes on residence 4,400 8,900

Interest on home mortgage 7,800

Charitable contributions:

Church contribution $ 3,900

Tickets to charity dinner dance

(Only the excess of the ticket price of $200

over the cost of comparable entertainment

of $80 is deductible) 120

Used clothing donated (limited to fair

market value) 450 4,470

Miscellaneous itemized deductions:

Uniforms ($370 cost + $172 upkeep) $ 542

Professional journals 250

Total of deductible items $ 792

Less: 2% of $97,450 AGI (1,949)

Miscellaneous itemized deductions deductible in 2003 -0-

Total itemized deductions $29,861

Alice and Bruce would elect to itemize their deductions because the total exceeds the standard deduction of $9,500 for 2003 for married persons filing a joint return.

(2) In addition to the Byrd’s two children, Cynthia and John, Alice’s mother qualifies as a dependency exemption because her Social Security benefits do not count as her own support when they are not spent for that purpose. Bruce’s father, Sam, qualifies as a dependency exemption under a multiple support agreement. Therefore, the deduction is $18,300 ($3,050 X 6).

Part 2—Tax Planning

Bruce’s salary ($53,000 X 1.06) $56,180

Interest income ($9,000 + $2,450) 11,450

Adjusted gross income $67,630

Less: Itemized deductions (Note 1) (12,912)

Less: Personal and dependency exemptions

(Bruce, Alice, 2 children, Alice’s mother) (5 X $3,100) (15,500)

Taxable income $39,218

Tax from tax rate schedule $ 5,168

Less: Prepayments and credits

Income tax withheld ($4,900 X 1.06) (5,194)

Net tax payable (or refund due) for 2004 ($ 26)

Notes

(1) Itemized deductions are summarized below:

Medical expenses:

Medical insurance premiums $7,100

Less: 7.5% of $67,630 AGI (5,072) $ 2,028

Taxes:

State income taxes ($1,900 X 1.06) $2,014

Property taxes on residence 4,400 6,414

Charitable contributions 4,470

Miscellaneous itemized deductions:

Professional journals $ 250

Less: 2% of $67,630 AGI (1,353)

Miscellaneous itemized deductions deductible -0-

in 2004

Total itemized deductions $12,912

50. Paul’s salary $ 58,000

Donna’s salary 56,000

Dividends 750

State income tax refund 1,520

Long-term capital gain (Note 1) 7,500

Adjusted gross income $123,770

Less: Itemized deductions (Note 2) (22,520)

Less: Personal and dependency exemptions (15,500)

(Paul, Donna, Larry, Jane, Hannah) (Note 3)

Taxable income $ 85,750

Tax from tax rate schedule (Note 5) $ 14,088

Less: Tax withheld ($10,300 + $9,700) (20,000)

Net tax payable (or refund due) for 2004 ($ 5,912)

Notes

(1) Sale price of 300 shares Acme Corp. stock (300 X $50) $ 15,000

Cost of stock (300 X $25) (7,500)

Recognized gain on sale (LTCG) $ 7,500

(2) Itemized deductions:

Medical expenses:

Doctor & hospital bills ($8,700 – $2,000) $ 6,700

Prescription drugs & medicine 640

Insurance premiums 2,810

Total medical 10,150

Less: 7.5% of $123,770 AGI (9,283)

Deductible medical $ 867

Taxes:

State income taxes paid ($900 + $800) $ 1,700

Real estate taxes 3,700 5,400

Home mortgage interest 7,890

Contributions:

Church $ 2,100

Books 740 2,840

Casualty loss:

Fair market value $18,000

Less: Nondeductible floor (100)

Less: 10% of $123,770 AGI (12,377) 5,523

Miscellaneous itemized deductions:

Air fare $ 340

Hotel 170

Meals (50% X $95) 48

Registration fee 340

Total deductible items $ 898

Less: 2% of $123,770 AGI (2,475)

Deductible miscellaneous itemized deductions -0-

Total itemized deductions $22,520

(3) Since Donna is the custodial parent, the Decker’s qualify for the dependency deduction for both Larry and Jane. Since they provide over 50% of the support of Hannah, they also qualify for a dependency deduction for her. Thus, the personal exemption and dependency deduction is $15,500 ($3,100 X 5).

(4) Consumer interest is not deductible. Therefore, neither the interest on the auto loan of $1,490 nor the credit card interest of $870 is deductible.

5) Tax on $750 dividend at 15% $ 113

Tax on $7,500 LTCG at 15% 1,125

Tax on remaining $77,500 ($85,750 – $750 – $7,500):

Tax on $58,100 8,000

Tax on ($77,500 – $58,100) @ 25% 4,850

$14,088

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: COMPREHENSIVE VOLUME.

49.

49. continued

49. continued

49. continued

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